Deadweight Loss

Assumption: Price-taking model, the efficient allocation point is Marginal value = Marginal cost, if government intervene the market, a misallocation of  resources will be occurred. The misallocation is called Deadweight Loss.

http://econman.uhome.net/A-level/Efficiency%20&%20Loss/Deadweight_loss.htm (Chinese version)

http://www.ssc.wisc.edu/~sseverin/lect20f01.pdf (The impact of price control on DWL, incl. Tax)

Application: Cost of Taxation

1. A Tax on good reduce welfare of buyers and sellers of the good, and the reduction of Consumer surplus and producer surplus usually exceed the tax revenue generated. The difference between the reduction of consumer surplus and producer surplus, tax revenue generated, i.e. the loss in the total surplus is called Deadweight Loss (DWL).

2. The tax has deadweight loss because the tax cause the buyers to consumer less and sellers to produce less, and this change in behavior shrinks the size of the market below the level that maximize total surplus (Decline in market size as the result of the tax).

3. The price elasticity of demand and supply measure how much market participants respond to the market conditions. So, it will also determine the size of DWL that occurs from the tax. The larger the elasticity, the greater the DWL

4. When the elasticity is nearly or perfectly inelastic, the DWL would be extremely small.

5. As tax grows larger, it distort the incentive more, DWL from the Tax increase.

6. Legal responsibility of the tax does not matter on DWL

7. Tax revenue rise with the size of tax initially. Eventually, the tax revenue will be dropped when a much larger size of tax is imposed on the market because it reduces the size of the market.

8. Laffer curve suggested that the tax cut will induce more people to work and then the tax revenue will have the potential to be increased. (Supply-side economics)

Application: Trade Restriction, Quota versus Tariff

http://www.bsos.umd.edu/econ/murrell/econ340/340_13.pdf

Assumption: the country is small country, which should be price taker in the market. The government intervention in the country cannot affect the world price.

Identical Items

• Decline of Consumer Surplus, compared with free trade

• Rise of Producer Surplus, compared with free trade

• Create DWL from overproduction and underconsumption

Difference

• Tariff - Government generate Revenue, Quota - Quota Holders making profit

Political economy in tariff versus quota

• Taxpayers prefer tariff

• Importer prefer quota

• Quotas must be allocated in auctions

If the country is having a strong economic power, extra effect by imposing tariff:

• Country actions change the world price

• Decline in the demand for imports

• World Price decreased substantially, this country can import in a cheaper price.

• Large country can gain by imposing tariff

• World as a whole loses

Glossary

Pareto Efficiency: Pareto efficiency is attained when it is impossible to reallocate resources such that one can gain without loss to others.

A type of efficiency that results if one person can not be made better off without making someone else worse off. Named after Vilfredo Pareto, this criterion is the guiding theoretical notion of efficiency used in the study of economics, especially welfare economics. Pareto efficiency is generally not attained if some resources are idle or unemployed. By engaging idle resources in production, some people can have more production without reducing that available to others. A problem with Pareto efficiency, however, is that it is based on the existing distribution of income and wealth. This is one of two noted efficiency criteria used in economics. The other is Kaldor-Hicks efficiency.

Pareto Improvement: Based on the Pareto efficiency criterion, the notion that an action improves efficiency if it is possible for one person to benefit without anyone else being harmed. A Pareto improvement is possible if the economy has idle resources or market failures. With idle resources, more production is possible to help some without hurting others. With market failures, corrective actions can eliminate deadweight loss that can then be use for benefits economy-wide. A contrasting condition for attaining efficiency is the Kaldor-Hicks improvement.

Pareto Optimal refers to a situation in which you can't make anybody better off without making someone else worse off. An analogy is an oversold plane, where there are 110 ticket holders for 100 seats. You could make any of the 10 standby passangers better off, but only by making one of the current passengers worse off. Note that this says nothing about the overall fairness of the system, or even overall efficiency. It simply describes systems where there is equilibrium. (More about Pareto Optimal)

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